What you need to know about the Senate's pass-through tax debate

How to tax a class of businesses known as pass-throughs is quickly shaping up to be one of the knottiest issues facing Republicans now trying to shuttle a sweeping tax code rewrite through the Senate.

Sen. Ron Johnson (R-Wis.) and Steve Daines (R-Mont.) are threatening to oppose the plan — and Republican leaders can only afford to lose two votes — because they say it doesn’t cut taxes deeply enough for those businesses. They worry corporations will see a far bigger tax cut, putting pass-throughs at a competitive disadvantage.

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The dispute is bringing the once obscure issue to the fore. Here’s what you need to know about the unfolding debate.

So what’s a pass-through? Pass-throughs are basically all the businesses that aren’t corporations. There are millions of them, and they include everything from law firms to hedge funds to your neighborhood dry cleaner. They include sole proprietorships (where one person owns a business), partnerships (joint ventures between at least two people) and limited liability companies and S corporations (both of which combine elements of corporations and partnerships).

They’re called pass-throughs because their income passes through to the owners’ individual tax returns, where it’s taxed at ordinary income tax rates, rather than being filed on a separate business return like a corporation. Currently, pass-throughs pay taxes topping out at 39.6 percent while corporations pay 35 percent.

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Why do Republicans want to cut their taxes? The short answer is because they’re cutting taxes on corporations. The corporate rate is one of the few U.S. taxes that is high by international standards — even higher than France’s — and it hasn’t been cut in 30 years. It’s what Republicans really want to cut, but they don’t want to look like they’re helping big businesses while forgetting their local hardware store, so they’re reducing taxes on pass-throughs as well.

How? The House would cut the tax rate on pass-throughs to 25 percent. If they do that though, while leaving the top individual income tax rate at 39.6 percent, they will create a big incentive for rich people to construe themselves as pass-throughs in order to qualify for the lower rate.

For instance, someone could set up an S corporation and have their employer contract with them, instead of hiring them directly. That would enable them to characterize at least some of their earnings as business profits, rather than wages, so it’s eligible for the lower pass-through rate.

The House aims to head that off by declaring that 30 percent of pass-through owners' income will be eligible for the pass-through rate, while the rest is subject to ordinary income taxes.

The Senate takes a very different approach. It would continue taxing pass-throughs at ordinary income tax rates but give them up to a 17.4 percent deduction for qualified pass-through income.

It tries to prevent rich people from gaming that by requiring people claiming the deduction to pay wages to someone else, and also by declaring those in certain industries ineligible for the break. It waives those requirements for people earning less than $500,000.

OK. Why such different approaches? It is one of the biggest differences between the House and Senate tax plans. Senate Republicans say the House plan doesn’t do enough to help small businesses. Remember the House plan cuts the pass-through rate to 25 percent. But many pass-throughs already pay 25 percent or less — 90 percent of sole proprietorships have $100,000 or less in receipts — so they wouldn’t benefit from the House’s reduced rate.

Many pass-throughs also object to the House’s 70-30 split between which money gets the special low rate and what doesn’t. What if there’s an aging patriarch of a small business, who started the company and continues to own it, but doesn’t do much anymore to run the company? Is 70 percent of his earnings really from wages?

Under the Senate plan, it doesn’t matter how much you make — everyone can get up to a 17.4 percent deduction. It also has much looser guardrails to prevent gamesmanship, which pleases pass-throughs that don’t want to be inhibited from taking the lower rate but worries some experts who say it willinspire new tax-avoidance efforts. But the Senate plan also doesn’t cut taxes on pass-throughs as deeply as the House.

So is it true, as Daines and Johnson say, that the Senate plan favors corporations over small businesses? That depends. A 17.4 percent deduction, combined with Senate Republicans’ top individualrate of 38.5 percent, means the highest-earning pass-throughs would pay a roughly 32 percent rate assuming they can fully take advantage of the deduction.

Not everyone will qualify for the entire deduction because it’s 17.4 percent of your income or half the wages you paid, whichever is lower. So if someone had $100 in income and only paid $20 in wages, then they’d get a $10 deduction, not $17.40.

Critics of the Senate plan say they’d pay even more because they’d lose a deduction for state and local taxes while corporations would be allowed to continue taking that break. And unlike Republicans’ proposed corporate tax rate cut, the Senate’s pass-through plan would expire after 2025, though lawmakers predict it would ultimately be extended.

Supporters of the Senate plan would note that corporate income is generally taxed twice — once at the company level and a second time when earnings are paid out to shareholders — so the proposal is fairer than it appears. If a corporation made $100, they would pay $20 in corporate taxes, under the Republican proposal. Then, when the remaining $80 is distributed to shareholders, they’d pay 23.8 percent or about $19, assuming it was paid to the wealthy. That would mean a combined tax bill of $39 on that original $100.

Daines and other skeptics respond that corporate income is taxed twice less often than it may appear, noting that roughly three-quarters of corporate dividends are collected by tax-exempt organizations like nonprofits and retirement funds and foreign investors.

Can they just cut taxes on pass-throughs more? They could, but GOP tax writers are constrained by their budget, which allows them to cut taxes by only $1.5 trillion. They have roughly $60 billion they can still spend, so they don’t have a lot of room to maneuver.

Also, a disproportionate share of pass-through income, especially from partnerships, goes to the wealthy, so increasing the 17.4 percent deduction threatens to make their plan tilted more heavily toward the rich, and Republicans are concerned about their plan appearing to be a windfall to the well-to-do.

Daines has suggested paying for bigger tax cuts for pass-throughs by crimping corporations’ ability to take that deduction for state and local expenses, though corporations will surely oppose that.